Bond Investing That Avoids the Bubble

Just about everyone knows that bonds are rapidly approaching bubble territory. Yields are at historic lows, pushing bond prices up to unsustainable levels. Headlines everywhere trumpet the fact that bond investors are going to be disappointed in future returns at the very least and are going to get absolutely killed at the very worst. But investors, nervous about a rapidly decaying global economy, keep stuffing money into the safety of bonds.

Despite their obvious disadvantages at this point in the market cycle, bonds should still be a vitally important part of many folks' portfolios, especially those in or near retirement. Fortunately, there are some areas of the bond market that are more attractively valued than others.

U.S. TreasuriesThis is one sector of the bond market that is pretty richly valued. While the U.S. faces many long-term fiscal problems of its own making, we're still seen as the best of the worst on a global scale, so the push into Treasury debt has been pretty spectacular in recent years. But with the yield on a 10-year Treasury bond hovering around 1.5%, it's hard to argue this sector isn't pricey and that investors are being adequately compensated for their investment.

So think twice about stocking up too heavily here. You can (and should) own some Treasury bonds as part of a fully diversified bond fund like Vanguard Total Bond Market ETF (NYS: BND) or iShares Barclays Aggregate Bond ETF (NYS: AGG) , but reconsider adding a meaningful allocation in additional bond funds or ETFs that focus exclusively on this sector.

Investment-grade corporate bondsTaking another step up on the risk/reward ladder are high-quality corporate bonds. These bonds aren't quite as safe as bonds backed by the U.S. government, but investors will be rewarded for taking on that extra bit of risk. While default risk is higher here than for U.S. government bonds, you're still fishing in a relatively safe pool of investment-grade securities. Even if another global recession emerges, odds are default would be fairly rare in this cohort. Bonds in this sector haven't seen quite the influx of money that Treasuries have, so there's a bit more opportunity here.

One inexpensive choice for getting exposure in this arena is PIMCO Investment Grade Corporate Bond ETF (NYS: CORP) . For a reasonable 0.20%, investors can get access to high-quality corporate bonds with a yield of about 3.2%. This corner of the bond market is likely to be the sweet spot in the near future, as it offers higher yields than comparable Treasury bonds without much additional risk.

High-yield bondsInvestors who are willing to take on an even higher degree of risk in their bond portfolio may want to delve into high-yield, or junk, bonds. Yields are a lot juicier in this sector, but default risk is higher, too. High-yield bonds have been getting a lot of attention, and money, from investors in recent quarters, so this sector isn't quite as attractively priced as investment-grade corporates, but there's still some potential here.

If you're willing to venture into junk bond territory, think about using SPDR Barclays Capital High Yield Bond ETF (NYS: JNK) , which will run you 0.40% a year. At last glance, the fund was yielding 7.3%, which is quite an inducement in this low-yield era. However, if economic conditions worsen, bond investors in this sector will likely take a hit. Since risk is elevated here, keep any junk bond allocations to a relatively small portion of your portfolio. Conservative types should bypass the sector altogether.

Emerging markets bondsBond investors who want a lot more spice in their portfolio might want to consider emerging markets bonds. As might be expected, risk and volatility are ways of life here. As such, this is another area in which to keep allocations very small. One fund to consider in this asset class is PowerShares Emerging Markets Sovereign Debt ETF (NYS: PCY) , which comes with a 0.50% price of admission and 5.1% trailing yield. Gains and losses can look rather stock-like here, as when the fund lost 19% in 2008 and gained nearly 36% the following year.

Given the current global outlook, emerging markets debt is a very risky place to be. Nonetheless, this area should provide additional diversification and greater long-term return potential for investors who can stomach the inevitable ups and downs.

Ultimately, while the long-term outlook for bonds in the coming years is not promising, many folks will still need a hefty helping of fixed income in their portfolios. While abandoning the bond market shouldn't be an option on the table for any investor, smarter bond investing will be required to sidestep what will likely be subpar returns for much of the fixed-income asset class.

Bonds can help preserve your capital and reduce volatility in your portfolio, but you won't be able to reach your retirement goals on a bond diet alone! Be sure to check out our newest special free report that highlights theshocking truth about your retirement. Don't miss this chance to grab your free copy of thiscan't-miss reporttoday!

Amanda Kishis the Fool's resident fund advisor for the Rule Your Retirement investment newsletter. Amanda owns shares of iShares Barclays Aggregate Bond ETF.Tryany of our Foolish newsletter servicesfree for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has adisclosure policy.